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Our guest this week is Jon Hale, Morningstar's head of sustainability research. In that role, he directs our research into the environmental, social, and governance investing practices of mutual funds and exchange-traded funds. An incisive analyst and writer, Hale authors the biweekly "Sustainability Matters" column on Morningstar.com. He's regularly quoted by the media on ESG matters and speaks often on sustainable investing at industry conferences and other events. Prior to assuming his current role, Hale held a number of other leadership positions in Morningstar's research and investment management divisions, most recently serving as head of manager research in North America. Hale, who holds the Chartered Financial Analyst designation, earned his undergraduate degree at the University of Oklahoma and his doctorate at Indiana University. We're pleased to have him as our guest.

Ptak: Our guest this week is Jon Hale. Jon is Morningstar's head of sustainability research. In that role, Jon directs our research into the ESG investing practices of mutual funds and ETFs. An incisive analyst and writer, Jon authors the biweekly "Sustainability Matters" column on Morningstar.com. He's regularly quoted by the media on ESG matters and speaks often on sustainable investing at industry conferences and other events. Prior to assuming his current role, Jon held a number of other leadership positions in Morningstar's research and investment management divisions, most recently serving as head of manager research in North America. A CFA charterholder, Jon earned his undergraduate degree at the University of Oklahoma and his Ph.D. at Indiana University. We're pleased to have him as our guest.

Ptak: It's our great pleasure. So, what we're going to talk about sort of the larger imperative for ESG in a minute, but maybe for the benefit of some of our listeners who are less familiar with ESG, let's start with some definitions. ESG has lots of buzz around it, but maybe you can demystify it for what is ESG and have we seen investors coalesce around a common definition for ESG?

Hale: Yeah, I think we're getting pretty close to that. Of course, ESG, the initialism refers to environmental, social, and corporate governance issues. And I think the most succinct way I could define it would be to say that a sustainable investment strategy is one that generally integrates the assessment of ESG issues at all points in the investment process, including stewardship or active ownership—which maybe we'll talk about a little bit today—and also attempts to deliver what I would call impact alongside financial return. And so, all ESG strategies or sustainable investment strategies, I sort of use those terms interchangeably. They're not all doing exactly the same thing. But I think those are the elements that they have in common.

Ptak: Sure. So, to put it into even more tangible terms, what would it look like when a firm is upholding best practices with respect to environmental, social, and governance practices? What should they expect to see, or conversely not see, in those cases?

Hale: So, referring to a company that's being invested in or an asset manager?

Ptak: Let's say a company that's being invested in that we're evaluating to see whether it's upholding those best practices?

Hale: Yeah. I mean, I think it depends on the ESG investor. In some cases, what they're looking for is kind of a baseline of evaluation on ESG issues. So, how is the company handling the material ESG issues that affect that particular industry? They're comparing that company's performance to its peers and saying, essentially, you know, is it good enough to kind of pass that hurdle and now we can consider putting it into a portfolio based on maybe other kinds of investment criteria. That's one way to do it. In other cases, investors are really looking for this idea of is the company addressing its—what I would call more broadly—its sustainability challenges in a way that is going to enhance its long-term value to really all its stakeholders, including its shareholders. So, there's a range of the way. But I think, for companies, it's a really useful concept. And I think more companies are starting to understand this. And it's not just coming from investors and saying, "OK, what data do we need to provide you about ESG issues?" But the sustainable investors, I think, helping companies understand that, "OK, here's a list of issues that sort of intangible, they're not completely financial in nature that affect or could affect the long-term value of the company." So, it's I think helping companies understand that as well and understand what issues they need to take account of going forward.

Ptak: Sure.

Benz: Going back to terminology, you mentioned that you use ESG and sustainable interchangeably, but I think people really get themselves in a twist over these different terms. So, let's start with the old term that we used to use, SRI, and talk about how not just the language has evolved but actually the underpinnings of sustainable strategies—how they've evolved from SRI, what that was to ESG to maybe the next evolution of that, which might be more, sort of, impact investing.

Hale: Yeah. So, it is a bit question of semantics, but circa the turn of the century or the 1990s, when we would refer to socially responsible investment strategies, it generally referred to kind of looking from the standpoint of an investor who was saying, "You know, I want my portfolio aligned with my values." And how do you do that? Well, at the time, from a methodological standpoint, really the only thing you could do very systematically was to exclude certain kinds of businesses that had, that might be involved in tobacco or alcohol or something like that. It was very much driven by institutional religious investors or asset owners that wanted to do this. And that was kind of the nature of it. Although one thing that was happening, going back earliest days—we've just been doing some research on this—end of the 70s was shareholder activism and the idea of engaging with companies around certain kinds of practices. So, that was actually started back in the era of SRI investing.

But I think a couple of things that have changed. One that's internal to the investing process is the development and the collection of very sophisticated amounts of and large amounts of ESG data about company performance and the conceptual move towards considering that ESG data and investment analysis based on its materiality. In other words, when I'm investigating or analyzing a company in a particular industry, what are the material ESG issues that really can affect company value, industry by industry? In the old days of SRI, it was just kind of a general concept of we want companies that are good on corporate responsibility and corporate behavior and don't have any big negative marks against them in terms of, sort of, overall corporate responsibility. So, it's really gotten more focused on materiality. There's much more data to be brought to bear. And it's not so much based on values, I think, anymore for investors as much as it's based on really wanting to drive the long-term value of an investment, as well as recognizing that this might be a way of investing that could help over the long run address even broader societal issues and problems. That's where the impact comes in today.

Ptak: So, maybe give us some context on why you think ESG has come to be entwined with investing the way it has. Is investing for maximum risk-adjusted return incompatible in some ways with sustainable investing practices?

Hale: I mean, it's a great question. And the way I look at it really is this: from a big-picture standpoint. I think we're in the midst of a paradigm shift in terms of how we think about the scope of investing, which in turn is related to a shift in thinking about the purpose of the public company from—we're sort of shifting from this idea of shareholder primacy, which kind of implies like short-term profit maximization for investors. I think to one that focuses on delivering what is often being referred to as long-term sustainable value to all stakeholders in a company, which would include customers, employees, communities, up and down the supply chain in which the company operates, the planet itself, given climate change issues, as well as shareholders. And I think that change in turn is part of an even larger shift towards what I call sustainability thinking, which really emphasizes in decision-making this more holistic idea that considers the long-term impact, and broader impacts, of the decisions that are made. And so, I think that sustainable investing is really about making investment decisions that are more long-term oriented, that recognize that long-term shareholder value is something that's a part of a company delivering value to all of its stakeholders over the long haul, and that also will result in companies minimizing their negative externalities on, you know, society, environment, et cetera and even working towards the repair of the climate. So, I think, it's part of that bigger picture. And I think that's what's really changed. And so, when you look at what SRI investing was about in the 1990s versus what sustainable investing is about today, in some ways, there's a line, you know, direct line from one to the other. But the relevance, I think, has changed immensely.

Benz: At the risk of belaboring my definitional questions, is impact investing different from sustainable investing?

Hale: So, I think, impact investing—again, that's one of these terms that sort of is used interchangeably. But here's the way I would distinguish: I would say that both focus on ESG criteria and evaluation and a focus on impact are part of the broad scope of sustainable investing. I think that investments in public companies have impact and I think the way they have impact right now is that if you think about a company management that is trying to shift to this sort of new paradigm of stakeholder value, what they've been thinking in the past is that, well, it's our investors, it's our shareholders that are limiting us to do that. They're also focused on short-termism that we can't focus on the long term. The bigger your base of sustainable investors in your investor base, the more leeway that a corporate management has to shift in this direction. So, I think it's very impactful. All that being said, the more-narrow term “impact investing” often is used to refer to investments that are very focused on a discernible, measurable impact. So, the impact I just described is pretty general. It's not something that my investment in one particular fund with the amount of assets I have is not going to necessarily create a huge amount of impact. And so, there are more narrowly gauged types of investments that are impact-oriented that they deliver. They say, "Here's the additionality, here's what's going to happen because of this particular type of investment." Oftentimes, those are not investments in public funds, whether they're fixed income or equities—although in the fixed-income markets, there are some, you know, if you focus kind of on the use of proceeds of things like green bonds and things like that, they're getting more towards this impact. So, impact is a component I think of sustainable investing.

Ptak: Widening out a bit, how should we think about the transmission mechanism, so to speak, for ESG? Suppose investors make choices based on ESG factors or criteria, and so, how should they expect those choices to be translated into better environmental, social, or governance practices and outcomes?

Hale: So, I guess, I would answer that this way that the way I look at it is that it's not those kinds of demands on companies are not coming only from investors. They're also coming increasingly from consumers, customers, as well as employees of a company. So, you've got kind of an alignment among these stakeholders, saying to companies, you know, we expect you to be addressing the key ESG issues that either are affecting the company in terms of its own value, or that the company's impact is impacting.

Benz: Is there a recent example of that where you have seen these other stakeholders, sort of, line up to press a company in a given direction?

Hale: So, certainly Amazon's employees have become quite active and it's a very interesting development in pursuing certain activities from Amazon's management that relate to climate issues as well as some of the development actually of their technology and how it's going to be used in facial recognition and that sort of thing. So, that's aligned with what investors are doing. So, companies are, I think, seeing this from a variety of different perspectives, not just from shareholders. It's not just as limited to shareholder demand. Another interesting comparison, though, to the old SRI, back in the day, that might have been the only place where management was hearing about these kinds of issues is from a few SRI investors. Well, today, when management hears about these issues, the chances are they're hearing it potentially from their own customers, as well as increasingly from employees that appear to be more emboldened today to be concerned about those kinds of issues.

Ptak: This is a question you probably get often. Some—Warren Buffett comes to mind—have argued for separating the two things. There's the "do well" and the "do good" and "never the twain shall meet." And so, what's your rebuttal to that? Why shouldn't firms continue to adopt the shareholder as their key constituency, the one that they're really answerable to and then, basically, those shareholders can decide through their philanthropy or other means how they're going to satisfy these other objectives, which may be important to them?

Hale: So, you're asking me to debate Warren Buffett?

Benz: I've heard this from financial advisors as well, Jon, where they say, "You know what, we just try to maximize aftertax returns. And then, I tell them to give to charity and approach it that way.”

Hale: Well, yeah. It's really—and again, I think it goes back to the paradigm shift—it's really talking kind of past each other. It's two different things. For one thing—and we can we can get to this in a little bit maybe—but for one thing, you can maximize your financial return, or you can expect and should expect financial returns through sustainable investments that are the same as, at minimum, the same that you are getting with a conventional investment. So, either way, you're going to have pretty much the same pot of money to decide what you want to do with it, whether you want to spend it on your own retirement or philanthropy, fine. So, there's that.

But I think more broadly speaking, it's that, you know, the way the world is working today, there are just different kinds of expectations on companies coming from different stakeholders. Customers today—and we're seeing this in survey after survey—but you also see it anecdotally in things like consumer boycotts, or just the talk about any instance of a "corporation" behaving badly. It used to be the case where something like that happens, and a company would typically say, "You know, let's turn this over to the PR department with the mandate, get this out of the headlines." And in the old prior eras, you know, there's not that much time or space in traditional news media to continue to hammer the story. So, it could be out of the headlines and investors would typically look at something like that as a buying opportunity. It's just a temporary, maybe blip, and a hit on the stock price and nothing fundamental changes about the company. Well, today, that's just not the case.

Consumers are much more connected and networked with each other. And any instance of a corporation behaving badly, it can live on for forever essentially. And so, the company's response to it is not necessarily any longer going to be, "It's a PR problem." We got to actually deal with this issue. Employees today—and I think similarly speaking, so you have consumers who are much more willing in their consumer behavior to consider these kinds of issues. I mean, I do it way more today than I did 10, 15, 20 years ago to take into account these things. It's not always what I do when I make a consumer decision; but it's definitely a part of it and can be even a greater part of it if there's some pressing issue that you are able to hear a lot about. An employee similarly … I mean, it used to be the case where, I mean, I think if somebody wanted to work for a for-a-profit company, they kind of made this decision that, well, I might be very interested in this kind of work and all that, but I'm working for this company to make a certain amount of money, and this is what I do. And then, even in my other activities, aside from working at my company, I'm going to—I can volunteer my time and do things like that. It's not so much the case anymore. Business schools are reporting a complete shift away from this sort of profit-maximization idea among business students to wanting to focus on sustainability and make companies work better and do better. And so, I just think that's the model of the corporation that we're headed towards. It's not just sustainable investors are a part of the push towards that, but so are consumers and workers. So, that's my general response to Mr. Buffett.

Ptak: Maybe shifting gears a bit: To what extent do you think the imperative for ESG is created by policymakers' failures in an action on things like climate governance, pay-equity issues? If we had a more vigorous policy response, do you think it would lessen the imperative for movements like ESG sustainable investing?

Hale: Yeah. I mean, it's a great question. And the way I think of it is that, again, in the midst of the old paradigm, the old way of doing things, yes, typically, if I as a consumer had some objection to some corporate practice that was going on, I wouldn't necessarily boycott and not buy a certain kind of product that I really wanted or something like that. But I would expect some action maybe in the political realm. And it hasn't happened. But I think one of the reasons why it's not – I mean, when you say failure of policymakers, I think, to me, it's more accurate to say that corporate influence on campaign, political spending, and lobbying expenditures has made it so they could turn around and control enough of the public policymaking process that the kinds of regulations that might be implied and preferred by consumers, employees, and more shareholders today don't happen through the political process. So, you are getting this kind of self-regulation. It's almost like direct democracy except it's like skipping over the political system completely and saying, OK, as a consumer, I've got some power to vote with my dollars; employees have some power as to what kind of companies they want to work for; and now, we're even seeing internally—you used to think, unless you were in a labor union, you couldn't speak up to management. But in a world where we have almost full employment, and particularly in industries where you have very well educated, and need really well-educated and innovative talent, they're willing to speak up, and investor is doing the same thing. So, it is kind of a regulating mechanism. And if we had, yes, more of that on the policy front, it might not have as strong of an imperative here.

Ptak: By the same token, it does seem that we're entering a new phase where ESG is being enshrined in regulations of various kinds. And so, do you consider that a welcome trend? And if so, why?

Hale: Well, I think there's two areas that are pretty important on the regulatory front for ESG. And I think one is clarifying the scope of fiduciary responsibility that would apply. So, that would clearly apply to ESG. There's still—and again, to me, it goes back to the paradigm shift. It's the fiduciary responsibilities kind of seems to be in a lot of folks' minds limited to, is this investment appropriate in a kind of narrow, short-term profit maximization standpoint, rather than taking account of these broader issues. And I think that needs to be clarified. Because when you do it just sort of on the basis of case law, it's just kind of descending from the same concept. So, that's important to make clear.

Benz: So, is there a policy movement on that front in play currently in the U.S. anyway?

Hale: Not so much in the U.S. And it's really interesting in the Department of Labor opinions about whether it's appropriate to use SRI, ESG, sustainable investments under ERISA …

Benz: In a 401(k) plan.

Hale: … in a 401(k) plan. It's descended from law that was set in the early 1970s about what they call economically targeted investments, which don't really have a whole lot to do with ESG investing, but it's really the only thing to hang their hat on and economically targeted investments—it was an attempt to say, you know, for labor union pensions and things like that, like, if you're going to invest in some project as a part of your pension plan that has some economic impact that favors your, say, your unions. It has to be able to compete with conventional investments on the basis of its risk-return characteristics, or else it's inappropriate. And all the Department of Labor opinions on SRI ESG have descended from that. And it's very confusing and they've never really had a full-fledged statement that says, look, we think that incorporating consideration of ESG factors is absolutely permissible. The Obama administration sort of tried to do that. The Trump administration is slightly tacked in the other direction. And it's all kind of based on their interpretation of this early 1973 ERISA amendment. So, I think it's important to clarify in this new era that the consideration of ESG and these kinds of sustainability issues are clearly within the scope of fiduciary responsibility. And then, the other area of policy is, has to do with disclosure of ESG-related data. I think it's important there because companies today, I think, are much more willing to provide that kind of data. But right now, it's kind of still the Wild West. There are all kinds of data providers out there sending questionnaires, saying here's the information we want from you. It's all slightly different and nonstandardized. So, having a standard way to do that, that is moving pretty fast around the rest of the world; not so much in the U.S. at the moment.

Ptak: Maybe we'll shift to demand for a moment. Europe has been ahead of the rest of the world on ESG. Maybe can you give just sort of a layman's explanation for why that's been?

Hale: Well, I think, first of all, I think that in Europe, there's never been as much of an embrace of the traditional shareholder-centric version of capitalism that shapes investors as much. I think, secondly, in Europe, that a lot of investment in Europe is kind of driven by institutional-level investors. And I think they've been more quick to adapt to these kinds of issues and incorporate those. So, by that I mean that not only large institutional asset owners, like pension plans and sovereign funds and things like that, but even the banks and bigger institutions that control a lot of what sort of street-level investors would do. I think they're the ones that have embraced it more. And I think at the like individual-investor level on the ground, sure, there's a lot of general support for these kinds of issues and approaches. It's probably been greater than it has been in the U.S. as well. So, I think those are the key reasons why Europe has been ahead of the U.S.

Ptak: Sure. And for those listeners who maybe aren't familiar with why an institution in, say, Europe would be more attuned to ESG and socially responsible investing generally. I mean, why would that be? Why would an institution take a greater interest in those things than perhaps, sort of, a typical retail investor?

Hale: Yeah. Well, I think that for one thing, they are long-term investors. And so, I think they have a tendency to really embrace this idea that we're long-term permanent investors. And so, we need to focus on that kind of longer-term perspective than otherwise would be implied by a more sort of shorter-term stakeholder-centric approach. And so, I think they're really the first to address that. And I just think, at least in the most recent era, going back maybe all the way to the 1980s, on balance, Europe has had a slightly more progressive stance on a lot of issues than we've had in the U.S.

Ptak: Sure. Yeah. In the U.S. ESG has been getting more popular. But it's still fairly small. I think you've done a great job of chronicling the growth that we've seen in that space, but why hasn't there been more uptake? And what do you think it will be that ultimately catalyzes growth here in the States?

Hale: I think it's still a building trend that again relates to the shift in thinking that's just not fully in place. I think there's some really interesting stats on that. Virtually every survey that I've seen on the subject has a far greater level of support for ESG and sustainable investing than you would see reflected right now in the assets. But it's a very strong level of support. One is—the best, I think, example of this comes from Morgan Stanley. They've done a pretty extensive survey every two years since 2015. So, about the time we were starting our sustainable investing initiative in 2015, Morgan Stanley did a survey showing that 71% of their respondents were interested in sustainable investing. Now, that was a pretty good survey. It was 800 to 1000 investors who had at least $100,000 in investable assets outside of their 401(k) or their homes. So, it's a good survey, I thought—71%. So, I thought at the time, "Wow, that is unbelievable." It's hard to even think that that's … surely, that's not going to hold up when we see other surveys. But it has been pretty consistent. And just this past year, in 2019, they issued their third version of that and the overall interest level was 85%. So, 71% to 85%. Then if you break it down between those that said, I'm very interested versus I'm somewhat interested, that's changed as well. Almost completely reversed. In 2015, most of those 71% that said they were interested, said they were somewhat interested. Now, more say—way more say—they're very interested than somewhat interested. Then if you add on the millennials, and they oversampled millennials, it was 95% interest level in 2019, again, up from 2015, 2017, 2019. So, I just think it's building still.

And from an individual investor standpoint—we've been talking about millennials. A lot of millennials are now entering the phase where they're becoming more active investor savers, or saver investors. And so, I think it's just a matter of time, really, and I don't see some of these underlying imperatives going away as an individual investor, just because you've thought in your mind, OK, I'm going to invest this way. It doesn't mean you're going to call up your advisor the next day and, say, let's restructure my portfolio or you're going to make that first investment the next day. When it comes time for you to make an investment, the next time you do that, you're likely to move in this direction. So, I think that's one of the reasons why it's so …

And then, the other reason is that the intermediary community is still populated by so many advisors that really may not offer to their clients sustainable investing alternatives. Some of them may be sort of out and out opposed to the idea. But I think more generally, it's that it's a new area of expertise for an already-established financial advisor that kind of makes it difficult when you're sitting across from a new client or even an existing client and you want to be the person that's the expert in the room. And if all of a sudden, you don't feel like sustainable investing is something you have an expertise in, then you may give them kind of the wave off. Like, you know, no, you don't want to do that and try to get them off track on it. So, that limits things as well.

Ptak: Well, if you're sitting across from a financial advisor, who maybe was skeptical in the way that you described, or it just wasn't on strategy for them, given where their practice was at the time of the makeup of their clientele, I mean, what are the sorts of things that you would try to convey to them in explaining why ESG is going to become an essential part of what it is they deliver to clients? What are they missing?

Hale: Yeah. Well, I mean, I think a lot of them are missing the full impact of this, I think, transformation and thinking about what the scope of investing is about and about some of these changes that we've talked about, and primarily because they might be older and have an older and more established clientele that are also not necessarily focused on these kinds of issues. So, a lot of what I would say to them is like, "Well, think about your next generation of investors in your firm, next generation of clients, how are you going to appeal to those clients? I mean, here's the actual numbers of what they're saying they're interested in. Are you just going to give them the wave off or the next era of new clients?" So, it's a good way to start thinking about and positioning yourself for younger clients. And I think what I'm hearing is that a lot of financial advisors, some of their younger and newer members of their firm are the ones that are starting to focus in this area. So, they're definitely looking at it as a build to the future.

Ptak: I would imagine that one of the hurdles that they have to overcome, and it's probably true more broadly of investors is, the notion of defining and measuring success as a committed ESG investor. And so, good ESG isn't the same as good value and so far as there isn't yet a financially measurable way to assess ESG. Whereas with value, we can use measures like price/earnings or price/book, price/cash to assess value. And so, do you foresee this changing where when it comes to ESG, an advisor trying to demonstrate to their client that they've added value, that there will be a way to convey that to them in a real sort of convincing and emphatic fashion, the same way we do in financial realms?

Hale: Yeah. So, this gets back to impact and that idea that Christine, you asked me about earlier—one of the things we're seeing from asset managers is an increased focus on impact and on reporting, on how has investing in this fund made a difference on the impact side of things. So, a lot of that has to do with shareholder engagement that the asset manager has done and reporting on that, being much more transparent about what it entails, as well as just other kinds of metrics that are being developed, like, how much, what's the carbon footprint of this portfolio and things like that. So, that's one way. I mean, I think the other is also in performance. There's a long-standing concern that perhaps there's a trade-off on performance. And my view on that is that, first of all, you should not expect there to be a trade-off on performance. And that judging, generally speaking, from fund performance, ESG fund performance, there's no underperformance. When I say that, I mean, in general, there's no underperformance. There are plenty of strongly performing ESG strategies out there. You don't have multiple thousands to choose from the way you do in the conventional fund universe. But I now have on my list of sustainable funds and ETFs in the U.S., we're at 300 of those funds. And in 2019—I was just looking at this this morning—2019, 65% of those funds finished in the top half of their Morningstar Category. So, they're doing pretty well. They've done well for the last several years. So, a lot of these funds have only been alive since the financial crisis. So, they've not been through a huge downturn or different kind of market. Although, in 2018, they tended to hold up fairly well during the couple of blips we had in 2018. So, expect competitive financial performance. Don't accept underperformance. And then, let's focus on the kinds of impact that's delivered, would be the formula.

Benz: So, speaking of performance, one sort of old-fangled take on the ESG universe was that these companies were more growth-oriented, that the companies that cleared the old SRI screens tended to not be value companies. So, is that bias still persistent? Or has that kind of gone away? Or does it just depend on the strategy?

Hale: I think it is there to some extent, especially because, there are a number of ESG strategies that are underweight energy today, including many that are completely fossil-fuel free. So, that said, traditional energy is a smaller part of a typical index than it used to be. So, here's what I would say about that, that when it comes to growth orientation, one of the things I was looking at just over the past couple of weeks is, at Morningstar, we have this new measure of kind of the factor blueprint of a fund. And the top-performing ESG funds I looked at, you would think that you could almost overlay their footprints on top of each other and they'd be very similar, but they're not. There's a wide variety of approaches that are reflected on the financial side. Another thing I would say is that Calvert Management is a subsidiary of Eaton Vance, a long-standing ESG-oriented provider. They have index funds that are value index, core index, and growth index. All three of those index funds have outperformed this year and over the three and five-year terms for those that have records that long. So, you know, I think it's broad-based in a variety of different contexts that ESG funds have shown that they can hang with their competitors and not just in the growth space.

Benz: So, you mentioned the asset managers. And we've seen the asset managers even though assets have increased due to the strong market, they've been under pressure due to flows going to passive products. So, I guess, a skeptic might say, "Are they glomming on to ESG in an effort to wring some expenses out of shareholders? Is it a way to charge more potentially? Are there marketing considerations in the mix?

Hale: Well, clearly, I think that on the active side of things that ESG is an additional component that an active manager could sort of offer to say, you know, here's a distinguishing feature between what we do and what your passive managers do. So, I guess I would say, maybe an active manager could put ESG information to better use than a passive manager might be able to in a way that would add value. So, yeah, I'd say maybe. On the other side, I guess it's important to note that ESG is happening on the passive side of things as well. In fact, the bulk of the flows are starting to go to passive ESG strategies and just like it is in the broader universe. And we've seen just in the past three years or so a plethora of ESG index or passive-based products. So, I expect that on the passive side that we’ll see even bigger growth on ESG than we will on the active side.

Benz: Is a passive ESG portfolio a legitimate way to do it, in your view? What are the trade-offs if I go that route?

Hale: Well, I think, yeah, I think it's a legitimate way to do it. I think that there's a couple of things to be aware of. One is that, unlike, say, an S&P 500 index fund, that's the same fund essentially across every provider that offers one. But, say, a U.S. large-cap ESG passive fund is not necessarily the same thing. ESG indexes are built differently. So, you need to know what the index is all about. Like in some cases, an index might say, be based on the best half of ESG performers in a universe. In other cases, it might be optimized. It might just say we're taking a base S&P 500 index, for instance, and just re-optimizing the weightings in order to accentuate ESG performance, but you still got the exact same holdings. Also, ESG index funds typically do include a few exclusions, which could be different from fund to fund. So, they're not exactly the same investment the way an S&P 500 fund would be. And then, I think finally, a passive ESG fund can distinguish itself for sustainable investors on the basis of its engagement in active ownership activities. And so, increasingly, I think that's going to be a differentiating factor for those kinds of funds.

Ptak: So, maybe we'll shift gears and talk about how one makes an assessment of say a mutual fund that is incorporating ESG practices to different degrees. Obviously, very important. We've got a number of asset managers who have at least said that they're committed to these things. But sometimes they're opposers; they don't really follow through on it. And so, it makes it all the more important for one to do an independent assessment, which is something at Morningstar we try to do. We've popularized the globe ratings, which is the iconography that we use to denote how well a mutual fund portfolio is balancing ESG risks and opportunities, so to speak. So, I'm curious, what do you think a good ESG assessment looks like and what is it that you think makes our assessment through our partner Sustainalytics authoritative? What makes our approach to it better than some of the competing approaches that we've seen that are out there?

Hale: I think there's a couple of elements to that. One is that, on the ESG data-provider side of things—and I just think we should acknowledge this that there are different data providers and raters. So, Sustainalytics isn't the only one that's out there. We think it's one of the, if not the best, one that's out there. But there's not just a universally agreed-upon definition for like what is a sustainable company or what is a great ESG performer.

To me, there is more agreement than disagreement in that area. There's just a paper that just came out that I read this morning that talked about how provider A and provider B that they didn't disclose who the providers were, but that there was a fair amount of discrepancy between what was rated high and low. I think when we compared for our globe-ratings providers, when you coalesce that information at the portfolio level, there wasn't a huge amount of difference. So, anyway, that being said, it's kind of a caveat that we're not necessarily the be-all end-all in terms of the information we use.

Nonetheless, I think our globe rating, what it does is, relative to peers, it evaluates the ESG performance of the companies in a fund's portfolio, right? And so, I think it's been a really important way to kind of serve as a proof point for intentional ESG funds. If an ESG fund that holds itself out to be focused on ESG, an ESG-centric fund—which I mentioned earlier, there's 300 of them or so in the U.S.—they ought to have a 4 or 5 globe rating in our system. If they don't, then it's definitely worth asking the question of what are you doing and what would be the explanation? Maybe there are some … a lot of times, though, it's that this fund just really isn't doing ESG in as comprehensive of a way that you might think it is by virtue of it holding itself out that way. I think, though, for other funds—and our rating applies to all funds, all conventional funds that have sufficient coverage of the underlying stocks in the portfolio—it's a really useful way to just kind of get a sense of this new component of, I think, what a lot of people would regard as a kind of risk. You know, what are the ESG risks that a company has, and therefore, as you roll it up into the portfolio, how much sort of ESG risk is embedded in this portfolio? And that could just be a component of an overall analysis of a fund that I think we've, that we've established. And from my feedback, I think that asset managers have really—to a degree that I am at least somewhat surprised about—you know, they look at their globe ratings, and it causes them to have to answer the question like, well, are we comfortable with what we're doing in this area or not? And I think it's really spurred a lot of asset managers and portfolio managers to think harder about how they're handling ESG.

Ptak: So, at the company or issuer level, what do you think are the telltales of a robust ESG risk-assessment process? So, if you were to cover up the names of the different raters that are out there, our affiliate Sustainalytics, there are others who compete in that space and we just looked at their body of work. What are the things that we should be looking for to basically suss out which is the best of them?

Hale: Yeah. So, I think that a focus on financial materiality is a key.

Ptak: What's that mean for a listener to understand the term financial materiality?

Hale: Yeah. So, I think, the initial impression that a lot of folks would have about this whole concept of ESG is that there's some universal set of ESG criteria that any company should adhere to. So, it kind of goes back to that older conception of like, well, if a company's being socially responsible, that's what it is. So, how do we … So, the materiality is really saying that no, no, no, you know, every E- or S- or G-related issue that we could think of is not relevant to every single company. And in fact, certain industries have ESG-related issues that are clearly financially material. So, in an oil and gas company, for instance, obviously, carbon emissions, both in their own operations and in the use of their products, is a huge issue. It's not a huge issue in a lot of other industries. Also, in oil and gas, pollution from their production processes, workplace, employee safety, business ethics, particularly around climate change policy—those are considered material ESG issues there. But if you move to something like a consumer goods company, or say a soft drink company, it might be the health of your products. It might be packaging issues, things like that. So, materiality differs across industries. And I think that's really best practices among, you know, if you're looking at ESG ratings, like how do they focus on materiality, how do they handle that?

And I think, to a large extent, the entire industry of ESG data and evaluation is moving in that direction. It's been spurred by an organization called SASB, the Sustainable Accounting Standards Board, that clearly was developed to kind of mimic the impact of FASB, which was not that long ago where there weren't even standard financial accounting metrics and FASB helped usher that in. And so, SASB is trying to do the same thing. You can go online at SASB.org and see what they call their materiality matrix, which goes industry by industry and says, here's what we've determined to be the most material issues that would affect an ESG analysis. So, I think that's the biggest thing.

One of the things about the Sustainalytics ESG risk rating that we're now using as our framework for analyzing portfolios, is that at the company level you're able to compare a company's ESG risk with those of companies in other industries. They're on the same scale. So, some ESG data providers just look at ratings within an industry, with your own peer group. So, in a Microsoft and Shell, Royal Dutch Shell, tend to be pretty good performers within their industries. But that's all the data would tell you that they're both sort of equally good on ESG. With our Sustainalytics data, it shows not only that, but it also shows that Microsoft has way less ESG risk than Royal Dutch Shell. So, those are some of the, I think, components of strong ESG analysis and ratings.

Benz: So, we've been talking mainly about equities and equity funds. Let's discuss the bond landscape and sort of the relative sophistication of the analytics going on in the bond space.

Hale: OK. Well, fixed income is very interesting in conjunction with considering ESG and sustainability issues, partly because—and this gets back to impact—is that you can think about your bond exposure and your bond holdings in a portfolio, not only in terms of like who the issuer is, but in terms of what are the use of proceeds of the bonds in this portfolio. And so, sustainable fixed-income strategy can really focus on that kind of an outcome. And so, I think that's the sort of key difference that, you know, you can look at bond funds from the standpoint of evaluating their corporate issuers the same way you might look at, that an equity manager might look at it. But it's this additional component that I think is important and impactful for investors. It's really a lot easier in some ways for sustainable bond funds to talk about their impact than it is on the equity side.

Benz: Are there any asset managers that you think are way ahead of the curve in terms of fixed-income analytics and ESG?

Hale: Well, one fund that's done a great job on this is the TIAA-CREF Social Choice Bond Fund. That fund basically is structured like this: It says, well, you know, from a duration and credit quality standpoint, we're an intermediate-bond fund. So, if that's the kind of exposure you're looking for, we're perfectly appropriate fund for that. On the corporate side, we will evaluate according to ESG performance, fine. But we'll also have a segment of the portfolio—a sleeve of the portfolio—that is designed for high social impact. And those bonds all have to have, specific in their use of proceeds, some sort of green or sustainable focus to them. That fund said at the beginning—it started more than five years ago now—that we're going to try to have anywhere from 20% of our assets on up in this social-impact sleeve. Typically, they have almost half, 40% to 50% of their investments in that and they've performed up front very well, very strongly for investors. So, they've really delivered both of those things.

I think there's a lot of … One of the really interesting areas where I think we could really see this grow is in the muni space where you could really think about funds that focus on issuers that may be somewhat lacking in investor demand because of the socioeconomic status of the issuer. I mean, you still have to take into account credit worthiness there. And then also the use of proceeds for the kinds of projects that need to be done from an environmental or climate-resilience standpoint. So, there are a few funds out there starting to do that. But I think we could see a lot more in the not-too-distant future.

Ptak: My closing question actually has to do with some of the nuances of portfolio construction for those who are attentive to ESG issues. And I know that one of the things that's crept into ESG assessment is this notion of maybe a bit of large-company favoritism, insofar as they're better equipped to adapt to evolving ESG practices or respond to, say, surveys or inquiries from ESG raters; whereas a smaller company may not be resourced to do the same thing and therefore, wouldn't get covered or wouldn't get rated as highly. And, therefore, you see the larger-cap funds do a bit better by some measures than smaller cap. Do you think that that's a misconception that we've since gotten past or is that still something that the industry needs to work through?

Hale: Well, certainly on company-level ESG ratings, from that standpoint, larger companies do tend to do well, but larger companies are the ones that have the most impact on these kinds of issues. So, I think it's really important to be focused on those kinds of issues. So, the analysis of the sustainability of smaller companies, I think, tends to be at the investment level, much more qualitative in nature, and not as reliant on ratings—the ratings of the individual companies aren't as reliable, I think there. So, the focus is a lot more, I think, on business models and whether they are businesses that are building towards this idea of operating within the context of this idea of stakeholder value, or do they have products and services that they're developing in their business that are going to address sustainability issues going forward.

Ptak: Well, Jon, this has been great. Thanks so much for taking the time to come on The Long View. We've really enjoyed the insights that you've shared with us. Thanks again.

Hale: Well, thank you. My pleasure.

Benz: Thanks so much, Jon.

Hale: Yeah.

Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.

Benz: You can follow us on Twitter @Christine_Benz.

Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1. Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis or opinions or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)